Item 7 of the Franchise Disclosure Document (FDD) provides a prospective franchisee with the type and amount of expenditures it will incur before opening its franchise unit, as well as an estimate of the type and amount of expenditures it may incur during the initial period of operating its franchise unit. Our experienced attorneys could discuss the types of expenditures and supplemental information that a franchisor must disclose, as well as the best practices in disclosing such information under Item 7 of the FDD.
Under the Federal Trade Commission’s Amended Franchise Rule, 16 C.F.R. §436 (the “Amended Rule”), the information that a franchisor must disclose under Item 7 of the FDD is codified at § 436.5(g). The Amended Rule requires that franchisors disclose under Item 7 the expenses that a prospective franchisee can expect to incur during the construction and opening of its franchised business, as well as any additional expenses necessary to operate the franchised business during the initial period of operations. Before discussing what types of expenditures the franchisor is required to disclose under Item 7, it is important to note the format this information must take is specific.
Like Item 6, the information disclosed in Item 7 must be in a tabular, five-column format. At the top of the table, the franchisor must provide the title “YOUR ESTIMATED INITIAL INVESTMENT” in bold type and all capital letters. A franchisor should title the columns in the table, from left to right, as follows: “Type of Expenditure,” “Amount,” “Method of Payment,” “When Payment is Due,” and “To Whom Payment is Made.”
At the bottom of the table, the franchisor should include a “Notes” section, where additional information concerning any of the expenditures can be clarified. Particularly, the franchisor must provide a footnote in the Notes section indicating whether each expenditure is refundable, and if so, under what circumstances. Additionally, if the franchisor or its affiliate finances any part of the initial investment, the franchisor must provide information on the financing in a footnote, including the down payment, interest rate, factors of the interest rate, and an estimated loan repayment schedule. The franchisor may also provide in the footnote to refer to Item 10, which concerns financing, for additional details. Below is an example:
YOUR ESTIMATED INITIAL INVESTMENT
|Type of Expenditure||Amount||Method of Payment||When Payment is Due||To Whom Payment is Made|
|Initial Franchise Fee||$15,000 (note 1)||Lump sum||At signing of franchise agreement||Franchisor|
|Travel and living expenses while training||$2,500 to $5,000||As incurred||During training||Airlines, hotels, and restaurants|
|Equipment||$40,000 (note 2)||Lump sum||Prior to opening||Franchisor or vendors|
|Additional funds – 3 months (note 3)||$23,000 to $45,000||As incurred||As incurred||Employees, suppliers, utilities|
|TOTAL (note 4)||$80,500 to $105,000 (note 5)|
(1) See Item 5 for the conditions when this fee is partly refundable. We do not finance any fee.
(2) This payment is fully refundable before equipment installation. After installation, we deduct $3,000 installation costs from your refund.
(3) This estimates your start-up expenses. These expenses include payroll costs. These figures are estimates and we cannot guarantee that you will not have additional expenses starting the business. Your costs will depend on factors such as: how much you follow our methods and procedures; your management skill, experience and business acumen; local economic conditions; the local market for our product; the prevailing wage rate; competition; and the sales level reached during the initial period.
(4) Except as indicated, we do not offer direct or indirect financing to franchisees for any items.
(5) We have relied on our 24-years of experience in the muffler business to compile these
Under the “Type of Expenditure” column, beginning with pre-opening expenses, a franchisor must list all expenses required by the franchise agreement and all other costs necessary for a franchisee to begin its franchise unit. The types of expenditures a franchisor must disclose vary depending upon the nature of the franchised business. However, the Amended Rule supplies a non-exhaustive list of typical pre-opening expenditures that franchisors charge to franchisees, and if applicable to the franchisor. The following types of expenditures must be disclosed in Item 7:
In addition to these typical expenditures, franchisors must disclose any other specific required payments that franchisees will incur prior to opening, such as additional training, travel, and advertising expenses.
After providing all the pre-opening expenses under the “Type of Expenditure” column, the franchisor must provide, if applicable, the required expenses a franchisee will incur during its initial period of operation. The franchisor must title this type of expenditure “Additional Funds,” followed by the length of the initial period. This type of expenditure typically includes payments made to third parties, such as rent, equipment, and inventory, and other costs that are not previously disclosed in Items 5 or 6. As shown in the table, a reasonable length of the initial period is typically at least three months. However, the initial period will vary on the nature of the franchise business. Therefore, franchisors may use a longer period that is reasonable for the industry. Whatever the length of the initial period, the franchisor must disclose in a footnote the factors, basis, and experience they considered or relied upon to calculate their estimate of the “Additional Funds” expenditure.
Under the “Amount” column, a franchisor must state the dollar amount for each type of expenditure. However, if the exact dollar amount is unknown, the franchisor may provide a low-high range of the expected amount based upon the franchisor’s experience in the industry. If a range is used, the franchisor should indicate in a footnote how it arrived at the range by providing, for example, any assumptions made by the franchisor about the range, the variability of the costs disclosed, the methodology used to make any calculations, and any differences that may impact individual franchisees. For real estate costs that cannot be estimated by a low-high range, the franchisor may describe the approximate size of the property and building, and the probable location of the building, such as a shopping center, mall, or highway. The franchisor should include at the bottom of the table the total estimated initial investment, which should equal the sum of the amounts for the expenditures provided in the table. If a low-to-high range is used for any type of expenditure in Item 7 of the franchise disclosure document, then the total amount should also reflect a low-to-high range.
If a franchisor sells company-owned outlets to prospective franchisees, the investment made in buying a company-owned store need not be reflected in Item 7. However, if in the preceding fiscal year, the sale price of a company-owned outlet exceeded the highest initial investment for franchised outlets sales, then the franchisor should disclose that fact in a footnote in Item 7, as well as how much the sale of company-owned outlets in the preceding fiscal year exceeded the highest initial investment for the sale of a franchised outlet.
In drafting the necessary disclosures under Item 7 of the FDD, the franchisor should carefully review its business operations to determine the types of expenditures that its franchisees will incur. It is good practice to cross check the references in the “To Whom Payment is Made” column in Item 7 against Item 5, to verify that any expenditure due to the franchisor or its affiliates is provided for under both Items. It is similarly important that the franchisor not overlook uncommon fees that some franchisees are likely to incur, such as costs for deposits, site selection fees, real estate brokerage fees, insurance, and professional fees.
The franchisor should diligently draft the content of the footnotes in Item 7, keeping in mind that a prospective franchisee is likely to consult with lenders and advisors before entering into a franchise agreement. Therefore, the amount for each type of expenditure should realistically reflect the actual amounts incurred by franchise units already operating. If the amount of expenditures varies based on venue (e.g., if the costs for a shopping-mall location are significantly lower than those for a stand-alone site), this information should be disclosed. If combining the information for different venues in one table appears misleading or disorganized, the franchisor can prepare separate tables for each type of venue, or provide the information for the most frequently offered venue (or the type of venue the franchise system is trying to sell), and put the fee variance for the other venues in a footnote. Ultimately, consulting with a franchise attorney is the best practice to ensure that all the necessary disclosures under Item 7 are provided accurately and artfully.